Senior preferred: the new cuckoo in the covered bond nest
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Senior preferred: the new cuckoo in the covered bond nest

Senior preferred could prove a much more enduring threat to the viability of the covered bond market than the targeted longer-term refinancing operation (TLTRO) or the covered bond purchase programme (CBPP3).

CBPP3 has heavily distorted covered bond prices and caused some investors to leave the market. In contrast to the private sector, which is driven by rational price considerations, the European Central Bank’s primary concern is to meet its purchasing target, and so it is moving the covered bond market away from where investors want to buy.

But it gets worse. Price distortions caused by CBPP3 purchases have been exacerbated by the TLTRO. The super-cheap financing facility has cannibalised the supply of covered bonds, which would otherwise have been the cheapest source of bank funding.

CBPP3’s artificial boost to demand, twinned with TLTRO’s subsidised funding, have considerably affected the demand-supply balance, helping elevate prices and tighten spreads. But since both CBPP3 and the TLTRO are extraordinary and temporary measures, their effect must eventually dissipate.

The ECB conducted its last TLTRO in March and, with the European economy now starting to improve, market participants are slowly coming round to the realisation that the ECB could be set to announce a tapering of its asset purchase programmes in September. The combined impact is sure to cause covered bond spreads to widen.

However, just as these two central bank measures are set to end, covered bonds will face a far more enduring level of competition from what is effectively a new asset class — senior preferred.

The introduction of the French senior non-preferred class this year has effectively provided credit enhancement to old style senior preferred and pushed it up the capital structure. The lower probability of default and loss given default of this super-senior debt brings it directly into competition with covered bonds.

Admittedly, senior preferred does not enjoy the same low risk weighting of covered bonds. And because they are eligible for inclusion in bank liquidity buffers, there’s always going to be an element of structural regulatory-driven demand that boosts the appeal of covered bonds.

NSFR may penalise covereds

On the other hand, proposed rules on the net stable funding ratio are set to penalise covered bonds compared with senior unsecured, and ensure that banks always have a need to issue senior — particularly if the funding is competitive.

Banks striving to meet their regulatory capital requirements will initially lean more heavily on senior non-preferred with the result that senior preferred becomes a more rarely used funding tool. As senior preferred becomes rarer, spreads should tighten — just as covered bond spreads widen.  

Deals issued on Tuesday by UniCredit’s HVB subsidiary and Crédit Agricole clearly showed the direction of travel. 

The French €1.5bn 10 year senior preferred bond was priced 23bp tighter than initial guidance at 67bp over mid-swaps and had tightened even further by the market close. With almost €4bn of genuine demand and 150 orders it is not too difficult to see this debt breaking below 50bp before long.

With a big order from the ECB, HVB’s €750m nine year Pfandbrief attracted demand of just €900m and was priced at 10bp through mid-swaps. At 40bp over Bunds the deal looked cheap to govvies , but as risk appetite improves and the asset purchase programme comes to an end, this gap may become unsustainable.

From a regulated investors’ viewpoint, zero-risk weighted Laender and agency debt such as the EFSF’s 10 year, which was also issued on Tuesday, looks far more attractive. The EFSF’s deal not only incurred a lower capital charge for bank investors, it priced with a 12bp spread over HVB’s deal.

Covered bonds will always have a place, but taking into account asset encumbrance and the many new regulatory hoops that will need to be adhered to once covered bond harmonisation takes effect, senior preferred could well become the more popular choice over time. Even once public sector buying has gone away, the market still needs to watch its back.

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